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EC 260 > Lesson 3.1 > Flashcards

Lesson 3.1 Flashcards

1
Q

managers face decisions characterized by 2 conditions:

A

1) strategic nature

2) incomplete info

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2
Q

define risk

A

hazard or chance of loss

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3
Q

define probability

A

the likelihood or chance that something will happen

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4
Q

what is P(outcome A) with frequency definition of probability

A

r / R where R is number of times situation is repeated and if outcome A occurs r times

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5
Q

define frequency definition of probability

A

an event’s limit of frequency in a large number of trials

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6
Q

define subjective definition of probability

A

the degree of a manager’s confidence or belief that the event will occur

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7
Q

define probability distribution

A

a table that lists all possible outcomes and assigns the probability of occurrence to each outcome

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8
Q

2 rules in probability distribution

A

1) probabilities must sum to 1 if outcomes are mutually exclusive
2) probabilities cannot be less than 0 or greater than 1

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9
Q

formula for expected value of profit

A

sum of profit * probability for each outcome

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10
Q

define decision tree

A

a diagram that helps managers visualize their strategic future

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11
Q

what does decision tree represent?

A

represented situation as series of choices, each of which is depicted by a fork

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12
Q

explain decision fork

A

represents choice by which managers must commit to a strategy; represented by squares

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13
Q

explain chance fork

A

represents point at which chance influences the outcome

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14
Q

what do we do when a branch is nonoptimal?

A

we place 2 vertical lines through it

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15
Q

value of perfect info

A

the increase in expected profit if manager can obtain completely accurate info concerning future outcomes

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16
Q

why do managers purchase info?

A

to reduce uncertainty from imperfect or incomplete info

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17
Q

what is expected value of perfect info also?

A

reservation price for obtaining info (expected profit with perfect info - expected profit without perfect info)

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18
Q

define utility function

A

function used to identify the optimal strategy for managers conditional on their attitude toward risk / level of satisfaction attached to each possible outcome

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19
Q

what is the rational manager?

A

one who maximizes expected utility

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20
Q

what is utility?

A

value that is attached to all possible outcomes of the decision by manager

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21
Q

relationship between utility and monetary gain

A

Utility generally increases with monetary gain

22
Q

x axis and y axis of utility function

A

profit/wealth on x axis and utility on y axis

23
Q

define risk averters

A

when managers prefer a choice with a more certain outcome to one with a less certain outcome, when confronted with gambles offering equal expected wealth

24
Q

graph of utility function of risk averters

A

Graph increases with decreasing slope; diminishing marginal utility

25
Q

relationship between utility and monetary gain for risk averters

A

Increase in monetary gain of $1 is associated with smaller and smaller increases in utility as wealth/profit grows

26
Q

define risk lovers

A

when managers prefer a gamble with less certain outcome to one with a more certain outcome when confronted with gamblers offering equal expected wealth

27
Q

relationship between utility and monetary gain for risk lovers

A

Increase in monetary gain of $1 is associated with larger and larger increases in utility as wealth/profit grows

28
Q

graph of utility function of risk lovers

A

Graph increases with increasing slope; increasing marginal utility

29
Q

define risk neutral

A

when a manager maximizes wealth, regardless of risk

30
Q

relationship between utility and monetary gain for risk neutral

A

Increase of $1 in monetary gain is associated with constant increase in utility as wealth/profit grows

31
Q

graph of utility function of risk neutral

A

Increasing graph with constant slope; constant marginal utility

32
Q

utility function for risk neutral

A

utility is linear function of profit/wealth (U = a + b(profit)) where b is positive

33
Q

expected utility for risk neutral

A

E(U) = a + bE(profit)

34
Q

when is expected utility maximized for risk neutral

A

Expected utility can only be maximum when expected profit/wealth is maximum

35
Q

define standard deviation

A

a measure of variation or dispersion of a payoff about its expected value

36
Q

formula for SD

A

(sum of probability of occurrence * (profit - expected profit)^2)^0.5

37
Q

what does larger SD imply and why

A

Larger standard deviation implies greater risk; there is a greater likelihood probability would depart greatly from expected value

38
Q

what do managers assume when using SD as measure of risk

A

When using standard deviation as measure of risk, managers assume scale of project is held constant

39
Q

do larger investments have larger standard profit deviations?

A

yes

40
Q

how do we take into account scale of project when measuring risk?

A

To take into account of scale of project, measure of relative risk is required, this is the coefficient of variation

41
Q

formula for coefficient of variation

A

V = standard deviation / E(profit)

42
Q

define certainty equivalent approach

A

when a manager is indifferent about certainty and a gamble, the certainty equivalent (Rather than expected profit) can identify if the manager is a risk averter, risk lover, or risk neutral

43
Q

if certainty equivalent < expected net worth

A

risk averter

44
Q

if certainty equivalent > expected net worth

A

risk lover

45
Q

if certainty equivalent = expected net worth

A

risk neutral

46
Q

how can we estimate certainty equivalent?

A

indifference curves

47
Q

why do indifference curves for certainty equivalents slope upwards to the right as opposed to the ones in chp 3?

A

because the manager prefers less risk to more risk

48
Q

graph of indifference curves for certainty equivalent axes

A

Indifference curve graph has x-axis expected net worth and y-axis is risk (coefficient of variation), x axis where y = 0 is certainty equivalent

49
Q

what will indifference curve be if risk neutral?

A

horizontal

50
Q

what do indifference curves show?

A

certainty equivalent corresponding to various uncertain outcomes

51
Q

how to find risk premium from indifference curves?

A

from riskiness of investment, do ERR at riskiness - ERR at y intercept

52
Q

range of values SD can take

A

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EC 260 (11 decks)

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